Smart Money Looks Less Bright as Hedge Funds Lag S&P

For most of this year, the overwhelming majority of hedge funds have underperformed major stock benchmarks, a development that undermines the idea of mega-investors as market-beaters.

According to a report from investment bank Goldman Sachs , only 11 percent of hedge funds outpaced the S&P 500 through August 3. The report analyzed 699 hedge funds with $1.2 trillion of gross equity positions.

The average hedge fundreturned just 5 percent year-to-date, while the S&P 500 was up nearly 12 percent. Meanwhile, the average large-cap core mutual fund posted a 10 percent gain.

Hedge fund returns are highly dependent on a handful of key stocks. The typical hedge fund holds nearly two-thirds of its long equity assets in its 10 largest positions. For the typical mutual fund, that number is closer to 36 percent. (Read More: Yikes! Hedge Funds Caught With Their Pants Down).

As the Goldman study noted, being bullish on a small community of stocks functions as a double edged sword. The ownership concentration strategy tends to work in a rallying market, but performs poorly during choppy or flat markets, the study said.

Report: Most Hedge Funds Fail to Outperform S&P

A Goldman Sachs report finds only 11 percent of hedge funds have outperformed the S&P 500 this year, with David Bailin, Citi Private Bank. Most funds are conservatively positioned, he says, and have excess cash levels.

Although hedge funds cut some exposure to consumer discretionary, information technology and energy sector this year, they remained largely overweight these portfolio staples. Consumer names represented the most underweight sector.

As the markets pulled back in the second quarter, hedge funds scaled back on risk. Net long exposure fell to 43 percent from 49 percent, above the recent low of 36 percent in the third quarter of 2011 but still well below the 52 percent high in the first quarter of 2007.

In the second quarter, the S&P 500 lost 3 percent, while Goldman’s basket of “Very Important Positions” dropped 7 percent. That “likely [reflected] both a cause and symptom of fund underperformance and de-risking,” Goldman wrote.